IRS Will Tax 401(k) Savings Used to Buy Retiree Health Coverage

Employees who designate a portion of 401(k) or other savings plan contributions to pay for retiree health care coverage will be taxed on those contributions, the Internal Revenue Service says.

In proposed rules published last week, the IRS said such an arrangement is not entitled to tax-favored treatment and that such contributions would be included as taxable income to the employee.

While such arrangements have long been discussed, few employers have implemented them amid informal warnings from IRS officials that the arrangements are not entitled to the same tax breaks provided to other benefit plan designs.

“In the past, the IRS has not looked favorably on these arrangements,” says Amy Bergner, an attorney with Mercer Human Resource Consulting in Washington.

Now, with the IRS officially laying out its position through proposed rules, “it is the final nail in the coffin” of such designs, says Andy Anderson, of counsel with the law firm Morgan, Lewis & Bockius in Chicago.

“The IRS has made its position crystal clear,” says Kyle Brown, an attorney with Watson Wyatt Worldwide in Arlington, Virginia.

The appeal of such designs is obvious: Employees would make pretax contributions to 401(k) plans, the money would earn tax-free interest and then could be pulled out tax-free to pay for retiree health care premiums.

“It would be a triple crown of tax-free funding,” Anderson says.

But the IRS, in its proposed rules published in the August 20 edition of the Federal Register, says Congress has very “carefully and strictly limited the ability to prefund” health care benefits on a tax-favored basis.

Under federal law, employers can designate that up to 25 percent of their contributions to their defined-benefit pension plans be used to fund retiree health benefits, while a portion of assets from overfunded pension plans can be used for the tax-favored funding of retiree health care benefits so long as certain conditions are met.

Additionally, last year’s sweeping pension funding reform law includes a provision through which retired public safety officers can use up to $3,000 a year of their pension benefits to pay for retiree health care premiums on a tax-free basis.

So long as the retiree makes such an election and the amount is directly transferred by the plan to an insurer, the retiree will not be taxed on the amount.

Given how specific Congress has been in laying out rules for tax-favored funding of retiree health care benefits, “a broad exclusion permitting a tax-favored treatment of any distribution used to pay accident or health insurance premiums would be inconsistent with this intentional statutory scheme,” the IRS said.

Filed by Jerry Geisel of Business Insurance, a sister publication of Workforce Management. To comment, e-mail editors@workforce.com.